Virtually every trader has been guilty of making emotional mistakes when trading. Investors who are overly swayed by these emotions can suffer in the market, even if their original investment thesis was correct.
Emotional mistakes can harm all investors, including novice traders or even the most intelligent people. Isaac Newton once bought shares of a famous trading company just weeks after it doubled, and then later ended up losing around 70% on his investment. This commonly studied trading nightmare highlights how intelligence alone isn’t enough to win in the markets.
Technical knowledge and research are both a must in trading. However, it is also very important not to overlook the need to develop an emotion proof trading strategy and to stick to it when emotional stakes are high. The best way to succeed with this strategy is to understand the cost of common trading mistakes and to develop a review process to ensure you are staying true to your original investment goals.
The Psychological Pain and Cost of Trading Mistakes
A losing trade can be mentally painful for investors, and it is very hard to recover with subsequent wins in the market.
A study by Kahneman and Tversky in 1979 found that a $1,000 loss hits twice as hard as a $1,000 gain. This fact is very important for investors, as investors can make things worse by reacting emotionally to a poor trade and making worse trades after this.
It is equally tempting for investors to hold onto losses longer than planned, or to sell early after becoming excited about gains. Research by Coingecko found that 73% of losing trades were held longer than the trader’s original stop loss, while 81% of winning trades were closed prematurely before reaching profit targets. In many cases, investors develop a strong initial thesis and then deviate from it based on their reaction to gyrations of the market.
When your thesis has failed, and a trade is no longer attractive, it is often best to cut the loss. Adding to a position during a downturn, purely based on an emotional reaction to a sell-off, is often a bad move.
At the same time, you shouldn’t be afraid to hold onto a winning trade if the thesis still makes sense and there are additional catalysts in place. If you do decide to sell, it should be based on the valuation and future outlook of the company, rather than an emotional reaction to a strong short-term profit.
Both of these mistakes can massively erode your portfolio returns in the long run. Morningstar recently noted that poorly timed trades have cost investors nearly $4 trillion over the past decade. Selling a winner early and holding a losing trade too long can be painful mistakes for investors.
The best approach is to be 100% confident in your trading strategy and to study common trading mistakes so that you can prevent yourself from making emotional trading mistakes.
Top Trading Biases to Overcome
Understanding investor psychology can help you overcome some of the common hurdles that cause investors to underperform in the long run. Common culprits of inferior portfolio returns include hesitation, overconfidence, greed, and fear.
Below are five common psychological concepts to be aware of when you are trading.
Sunk Cost Fallacy: Sunk cost fallacy refers to the tendency of humans to continue investing time and energy into something, even when this decision isn’t in their best interest. In investing, this appears as an investor continuing to double down on a losing position when it would be better to cut the loss. Whether you are a long-term investor or trader, you are going to make mistakes. However, holding a position too long can further wreck portfolio returns and leave you with less capital to allocate to new winning trading strategies.
Hot Hands Fallacy: It is also very important to be on guard even after you start to execute successful trades. Many traders are guilty of hot hands fallacy when they become overconfident after making successful trades. A study from Stanford University found that winning contestants on Jeopardy were willing to bet $100-500 more when they were on a winning streak. This similar type of thinking has led many investors to become overconfident after a market rally, only to surrender these gains after making poor trading decisions.
Confirmation Bias: Investors who spend ample time performing due diligence can still be guilty of confirmation bias, which is the tendency to seek out information that confirms your existing beliefs. If you are bullish on a stock or industry, it is also important to seek out research and news from other investors who are bearish. Doing this can help you develop a well rounded investment thesis before initiating a position, and also help you know when to let go when the data changes.
Fear of Missing Out: Fear of missing out (FOMO) is another common trading mistake. During previous famous bull runs, such as the crypto rally or meme stock rallies in recent years, many investors piled into stocks after they rallied and were later wiped out during corrections. If your thesis is based around the regret of missing out on a trend and the fear of missing a subsequent rally, you are likely letting FOMO corrupt your trading strategy.
Analysis Paralysis: Sometimes too much research can lead to a costly mistake called analysis paralysis. Investors who are emotional and go overboard on analysis can become mentally trapped and fail to execute a trade that was intellectually solid. There are certain guardrails you can implement, such as establishing clear investment criteria and position sizing so that mistakes aren’t overwhelming. Performing these steps can help you know when you have put in enough research to make a trade, and will also help you not be too afraid of being wrong about individual trades.
Developing an Emotion-Proof Strategy
Once you have a solid understanding of your investment goals and some of the common emotional blocks that can get in the way, your next step is to develop a clear trading strategy and to commit to it in the long run.
If your goal is long-term capital accumulation to save for retirement, there is plenty of data to show that staying in the market is often the best strategy. Investors have missed out on returns simply because of panic selling during corrections or trying to anticipate a correction that never came.
If your goal is to become a better trader, it is very important to clearly define your strategy beforehand and to stick to it. Strategies like putting in stop loss or take profit orders can help you stay grounded when bull or bear markets kick in. You should also develop a clear investment timeline and exit the trade when it’s time to move on.
Regardless of how much capital you manage, it is still crucial to have a strategy and review it to hold yourself accountable. Actions like writing a quarterly review of your portfolio, in which you explain your trading decisions, can help you stay grounded and learn from your portfolio winners and losers.
-SRIV